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Question 5 - Activity-Based Costing and Management [20 Marks] Opsonin Inc manufactures three products for the pharmaceuticals industry: product P : annual sales, 8000 units. product Q : annual sales, 15 000 units. product R : annual sales, 4000 units. The company uses a traditional, volume-based product costing system with manufacturing overhead applied on the basis of direct labour dollars. The product costs have been calculated as follows: Product P Product Q Product R Raw material $35.00 $52.50 $17.50 Direct labour 16.00 (0.8 hr x $20) 12.00 (0.6 hr x $20) 8.00 (0.4 hr * $20) Manufacturing 140.00 ($16 x 875%) 105.00 ($12 x 875%) 70.00 ($8 x 875%) overhead* Total product cost $191.00 $169.50 $95.50 *Manufacturing overhead budget: Machinery $1 225 000 Machine setup 5 250 Inspection 525 000 Material handling 875 000 Engineering 344 750 Total $2 975 000 Opsonin Inc's pricing method has been to set a budgeted setting price equal to 150 per cent of full product cost. However, only the Product Q have been selling at their budgeted price. The budgeted and actual current prices for all three products are the following: Product P Product Q Product R Product cost $191.00 $169.50 $ 95.50 Budgeted price 286.50 254.25 143.25 Actual current selling price 213.00 254.25 200.00 Opsonin Inc has been forced to lower the price of product P in order to get orders. In contrast, Opsonin Inc has raised the price of product R several times, but there has been no apparent loss of sales. Opsonin Inc has been under increasing pressure to reduce the price even further on gismos. In contrast, Opsonin Inc's competitors do not seem to be interested in the market for Product R. Opsonin Inc apparently has this market to itself. Required: 1. Is product P the company's least profitable product? Explain your answer. [1 Marks] 2. Is product R a profitable product for Opsonin Ltd? Explain your answer. [1 Marks] 3. Comment on the reactions of Opsonin Inc's competitors to the firm's pricing strategy. What dangers does Opsonin Inc face? [2 Marks] 4. Opsonin Inc's financial controller, Obrien Sally, recently attended a conference at which activity-based costing systems were discussed. She became convinced that such a system would help Opsonin Inc's management to understand its product costs better. She obtained top management's approval to design an activity-based costing system, and an ABC project team was formed. In Stage 1 of the ABC project, each of the overhead items listed in the overhead budget was placed into its own activity cost pool. Then an activity driver was identified for each activity cost pool. Finally, the ABC project team compiled data showing the percentage of each activity driver that was consumed by each of Opsonin Inc's product lines. These data are summarised as follows: Activity cost pool Activity driver product Product Q product R Machinery Machine hours 25% 50% 25% Machine setup Number of setups 20% 30% 50% Inspection Number of inspections 15% 45% 40% Material handling Raw material costs 25% 69% 6% Engineering Number of change orders 35% 10% 55% Show how the financial controller determined the percentages given above for raw material costs. (Round to the nearest whole per cent.) [4 Marks] 5. Develop product costs for the three products on the basis of a simple activity-based product costing system. (Round to the nearest cent.) [3 Marks] 6. Calculate a budgeted price for each product, using Opsonin Inc's pricing formula. Compare the new budgeted prices with the current actual selling prices and previously reported product costs. [2 Marks] 7. Refer to the new budgeted prices for Opsonin Inc's three products, based on the new activity- based costing system. Write a memo to the company managing director commenting on the situation Opsonin Inc has been facing regarding the market for its products and the actions of its competitors. Discuss the strategic options available to management. What do you recommend, and why? [5 Marks] 8. Refer to the product costs developed in requirement 5. Prepare a table showing how Opsonin Inc's traditional, volume-based product costing system distorts the product costs of product P, Q and R. [2 Marks]